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Government Intervention and Failure

There are 3 ways in which a government intervenes in the free market through:

Legislation– By introducing laws or regulations that force firms to adopt a certain practise.

Financial Intervention – Achieved through fiscal policy the government can tax certain firms for externalities or conversely can provide subsidies to firms.

State Provision – The government may need to produce the good itself, for example with public goods that are missing from the free-market.

Government failure occurs if government intervention leads to a net welfare loss. It is where the government causes a misallocation of resources in a market. It may however be that government failure is less detrimental than the free market failure.

There are 2 forms of government failure; benign failure and malign failure. Benign failure occurs when the failure is an opportunity cost to the intervention. For example if the government provided a watchdog for a certain sector but the watchdog didn’t have any affect on the sector, then the only failure is the opportunity cost of establishing the watchdog (i.e. money and resources). However malign failure results when the intervention makes the problem worse by reducing economic welfare. For example if the watchdog forced the introduction of a bureaucratic process to a sector which was worse than the previous process, then they have caused disharmony and the failure will result in reduced economic welfare.

Government failure can arise from lack of information, administrative costs, political motives and conflicting objectives.

Example - Common Agricultural Policy (CAP)

After WWII the European Economic Community (EEC) developed the Common Agricultural Policy (CAP) in order to stabilise the incomes of European farmers. The problem was that price fluctuations resulted in farmers not knowing their profit for the year; this led to under-investment and also meant that consumers didn't know the price of bread and couldn't budget properly. 

In order to do this the EEC guaranteed prices to farmers for their crops, these prices were above the world prices and hence the EEC also enacted a tariff to prevent Europe from being flooded by cheaper imports - which would have undermined the price guarantee. 

CAP can be seen as a form of government failure as the EEC (a form of government) intervened in the market causing malign and benign failure. There is an enormous cost to the EEC to fund the program and it also causes economic welfare to fall in foreign markets. Because the EEC buy any surplus supply they usually have large stockpiles, previously they have 'dumped' these reserves on foreign markets causing prices to tumble (as supply exceeds demand) and reducing the earnings of foreign farmers. It also means that European consumers have to pay more for their crops than they may under a free-market system, as they are paying the price that the EEC set.

Page last updated on 20/10/13